Introduction

As long as the insurer is faithfully providing a defense to its policyholder, a lawsuit cannot be settled at an insurer’s expense without the insurer’s consent.[1] As a party to a lawsuit, a defendant has an initial legal right to settle, but not necessarily at the insurer’s expense. Liability insurance policies require the policyholder to defer to the insurer regarding any settlement that the insurer must pay. Standard policy language excuses the insurer’s obligation to pay for any settlement to which it does not consent.

But, an insurer that does not faithfully defend its policyholder may be unable to enforce some or any of the several contractual provisions of a standard liability policy that empower the performing insurer to take control of settlement. If an insurer wrongfully fails to defend, the policyholder and the plaintiff are free to negotiate a reasonable, non-collusive settlement and then seek payment from a defaulting insurer, unimpeded by contract language to the contrary. The rationale is that the insurer’s breach of the duty to defend leaves an abandoned policyholder to fend for oneself.

Control of Settlement Turns on the Insurer’s Performance of Its Duty to Defend

“[T]he insurer has the right to control defense and settlement of the third party action against its insured, and is generally a direct participant in the litigation.”[2]

“[W]hen a liability insurer wrongfully denies coverage or refuses to provide a defense, then the insured is free to negotiate the best possible settlement consistent with his or her interests. Such a settlement will raise an evidentiary presumption in favor of the insured with respect to the existence and amount of the insured’s liability. The effect of such presumption is to shift the burden of proof to the insurer to prove that the settlement was unreasonable or the product of fraud or collusion.”[3]

Policy Provisions

Liability Policies Make No Promise to Settle, Only an Option to Settle

A liability insurer’s implied “duty to settle” is an obligation arising from the broader duty of good faith and fair dealing.[5] The implied duty to settle recognizes the insurer’s obligation to avoid unreasonably exposing the policyholder to liability in excess of the policy limit and typically only arises when a plaintiff makes an offer to settle within policy limits.[6] However, no insurer is required to accept a settlement offer simply because is it within policy limits. Instead, the penalty for an insurer failing to accept a reasonable offer to settle withing policy limits is that it may be obligated to pay a covered judgment, even in excess of the stated contractual limit.[7] An attorneys’ consent to settlement is not required.[8]

However, “the assured cannot force the carrier to accept a settlement offer it does not wish to accept. For better or worse, like a married couple, assured and carrier must make the best of each other.”[9] “[A] defending insurer cannot be bound to a settlement to which it has not agreed and in which it has not participated.”[10] Thus, a policyholder may not settle at the insurer’s expense without a performing insurer’s consent.

Standard policy language requires the policyholder to notify the insurer of a lawsuit.[11] Courts freely enforce this provision since an insurer cannot be expected to discharge its contractual promises until it learns of a claim. However, the notice-prejudice rule excuses a policyholder of giving timely notice unless the insurer can demonstrate prejudice. “[P]rejudice must be shown [by the insurer] with respect to breach [by the policyholder] of notice clause.”[12] Separately from the notice provision of the policy, the enforceability of a settlement reached by a policyholder whose insurer has failed to defend may often be influenced by whether the policyholder has kept the insurer informed.[13]

The policyholder has a common sense duty and a contractual obligation to cooperate with a liability insurer. Standard policy language requires the policyholder to cooperate with the insurer in the investigation, settlement and defense of a third party claim.[14] If a policyholder violates the cooperation clause, the insurer must show substantial prejudice to enforce the breach against the policyholder. “An insurer may assert defenses based upon a breach by the insured of a condition of the policy such as a cooperation clause, but the breach cannot be a valid defense unless the insurer was substantially prejudiced thereby.”[15] Prejudice is not presumed by a policyholder’s violation of the cooperation clause. “[W]e are of the view that a judicially created presumption of prejudice, whether conclusive or rebuttable, is unwarranted.”[16]

Standard policy language prohibits the policyholder from spending an insurer’s money.[17] The “no voluntary payment” provision of a standard policy prohibits the policyholder from settling with a plaintiff and then seeking reimbursement from the insurer without the insurer’s consent. “California law enforces such no voluntary payments provisions in the absence of economic necessity, insurer breach, or other extraordinary circumstances.”[18]

Standard policy language sets forth a condition precedent to suing the insurer that a plaintiff’s lawsuit proceed to final judgment by an actual trial, unless the insurer consents to settlement.[19] Thus as a rule, neither the policyholder nor the plaintiff may settle with one another and then successfully sue the insurer unless this condition is first satisfied. “[A] defending insurer cannot be bound to a settlement to which it has not agreed and in which it has not participated. . . . [T]he claimant may not maintain an action for breach of the duty to settle because . . . the stipulated judgment is insufficient to prove that the insured suffered any damages from the insurer’s breach of its settlement duty.”[20]

“[W]here an insurer provided a defense to its insured in the underlying litigation, and the insured, without the participation or the consent of the insurer, stipulated to a judgment without evidentiary support and with no potential for personal loss, such judgment is insufficient to impose liability on the insurer. To hold otherwise would create in the insured the ability to escape all liability for his or her own wrongdoing while imposing on the insurer totally unsupported liability. The potential for fraud and collusion is evident.”[21]

A Defaulting Insurer May Not Enforce Contract Provisions

Some or all of the foregoing contract provisions may be rendered unenforceable if the insurer is itself in breach of its contractual obligation to defend. “It is a well-recognized rule that the insurer may not repudiate the policy, deny all liability, and at the same time be permitted to stand on a provision inserted in the policy for its benefit.”[22]

“The denial of liability on the part of the insuring company and its refusal to defend the suits constituted such a breach of the contract that the insured was released from his obligation to leave the management thereof to it, and was justified in proceeding to defend on his own account.”[23]

“[I]f an insurer improperly refuses to defend the insured, the insured is entitled to make a reasonable settlement of the claim in good faith and may then maintain an action against the insurer to recover the amount of the settlement.”[24] “[I]f the insurer wrongfully refuses to defend, leaving the insured to his own resources to provide a defense, then the insurer forfeits the right to control settlement and defense. In that event, the insured is free to settle the lawsuit on his own, and the insurer is bound by a stipulated judgment.”[25] “When an insurer wrongfully refuses to defend, the insured is relieved of his or her obligation to allow the insurer to manage the litigation and may proceed in whatever manner is deemed appropriate.”[26] “Once [the insurer] wrongfully denied a defense, it gave up the right to control the litigation and could not insist that [the policyholders] use [dependent counsel] in order for [the insurer] to cover attorney’s fees.”[27]

However, this rule does not apply to an insurer that is defending, even if the defense is lackluster or the attorney conducting the defense is doing a poor job. “[N]either the adequacy of the representation nor the effectiveness of the defense are relevant to the question whether the insured can enter into a binding settlement without the insurer’s consent.”[28]

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[1] Some policies require the insurer to obtain the consent of policyholder to settle.

[6]Duty to Settle “Under these circumstances the implied obligation of good faith and fair dealing requires the insurer to settle in an appropriate case although the express terms of the policy do not impose such a duty.” (Comunale v. Traders & General Ins. Co. (1958) 50 Cal.2d 654, 659.)

[19] Typical No Action Clause – “Actual Trial” Provision: “No action shall lie against the company . . . until the amount of the insured’s obligation to pay shall have been finally determined either by judgment against the insured after actual trial or by written agreement of the insured, the claimant and the company.”